Are Equity Returns Dependent On Easy Money?

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by: Charlie Bilello

The Fed raised interest rates this week for the third time since December 2015. This has many investors concerned about the impact on the stock market. Monetary policy has been abnormally easy for years now while stock market returns have been strong, leading many to conclude that the opposite situation could be problematic.

While that may indeed be the case, we need to evaluate the historical data to determine if such a conclusion is actually supported by the evidence or is merely a subjective opinion. We'll approach this by answering a series of questions.

What is "easy" monetary policy?

There is no textbook definition, but a good rule of thumb is to compare the Fed Funds Rate to core inflation. If the Fed Funds Rate is well above core inflation, monetary policy is tight. If it is well below core inflation, monetary policy is easy.

Is monetary policy "easy" today?

Using that simple definition, monetary policy remains extraordinarily easy today even after the third rate hike. With an Effective Funds Rate of 0.87% and Core CPI of 2.2%, the real Fed Funds Rate of -1.3% is in the lowest 20% of readings going back to 1958.

Are equity returns "dependent" on easy monetary policy?

If we break down the real Fed Funds Rate into quintiles, we find that the S&P 500 has experienced its highest annualized returns during periods of easy monetary policy (lowest real Fed Funds Rate) and lowest annualized returns during periods of tighter monetary policy (highest real Fed Funds Rate).

Does that mean equities are "dependent" on easy monetary policy? Not exactly. As the table above illustrates, the returns are still positive and quite strong in periods of tighter monetary policy, they just aren't as strong as the easiest quintile. As such, a strategy that only invested in stocks during periods of easy money would be trounced by a simple buy and hold of all periods.

What about the future? Should investors be expecting strong returns to continue given that monetary policy remains easy?

We've generally seen stronger returns with a higher probability of a positive return following periods of easy money. That phenomenon seems to be most pronounced in the short run (6-months through 1-year).

Importantly, that does not mean that returns following tighter monetary policy regimes have been poor. As you'll notice in the table below, the highest 7-year forward returns (12.9% annualized) actually followed the tightest quintile. This is due in large part to data points in the early 1980's when the Fed was trying to curb inflation, after which U.S. equities experienced huge gains. The Fed has not operated in this tightest quintile since 2001, which brings us to the most important question.

Is today's market environment comparable to prior "easy money" periods?

No. The Fed is now almost nine years into the longest stretch of easy monetary policy in history. Prior to 2008, extreme easy money (lowest quintile) policy was limited to years during or closely following a recession (1958, 1970-71, 1974-77, 1980, 1992-93, and 2001-04).

In contrast, this June the U.S. expansion will hit eight years, and the Fed has operated with a negative real Fed Funds Rate the entire time. To expect forward returns to be as strong as they were in 2009 simply because money is still cheap would be a mistake. Why? Because valuations are not nearly as compelling (see my recent post on this here), and valuations have been a far stronger predictor of forward returns than Fed policy.

As much as we'd like to compare 2017 to prior years and prior Fed regimes, the truth is that everything about today's environment is unprecedented:

  • The Fed moved rates down to 0% back in 2008, the lowest level in history.
  • The Fed waited seven years to raise interest rates from that trough level, the longest waiting period in history.
  • The Fed expanded its balance sheet by $3.7 trillion (from $800 billion to $4.5 trillion) through three rounds of quantitative easing, and continues to reinvest interest/principle today.

So this time has already been quite different than the past, and we should therefore be prepared for entirely different outcomes in the future. That doesn't mean easy money cannot be helpful to stock prices in the short-run, all else equal. It can be, but the problem is all else is never equal. That statement is truer today with respect to monetary policy than perhaps any other period in history.

Which is why one should be extremely careful in basing their investment decisions on the Fed. Easy money is not a panacea for the stock market, just as tighter monetary policy isn't necessarily bad for stocks. The overall evidence shows that Fed policy simply hasn't impacted stock returns nearly as much as people think. And given today's unprecedented environment, what little it has meant in the past may not be applicable in the future.